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A VAT Won't Produce Instant Revenue, Easily Collected Revenue, Or Fairness

27 Mar 2010
Posted by Pete Davis

 "As the night follows the day, VAT follows health care reform." That's how Charles Krauthammer started his Washington Post op-ed yesterday. He blissfully implies Uncle Sam can flip a switch and collect a trillion dollars over 10 years for every percentage point of VAT, "the ultimate cash cow." I beg to differ.

Some of the lessons I learned from my experience formulating Al Ullman's VAT proposal of 1979 include:
  1. Like, the U.K. when it adopted its VAT in 1973, the U.S. will struggle for at least two years and probably longer to implement a VAT. Hundreds of thousands of small businesses would have to register with the IRS and have their sales and remittances monitored. The IRS would have to hire tens of thousands more agents. Exemptions will alleviate some of that problem, but a VAT exemption still hits those businesses with the tax. The income tax looks bad now, but wait until you see this.

  2. Compared to our income tax, the VAT is regressive. The poor and the elderly will be particularly hard hit because they consume more than their income out of transfer payments and wealth. To alleviate that, there will be tremendous political pressure to "zero rate" food, housing, and medical services, roughly half of the VAT personal consumption tax base. My work with the Treasury Tax Model showed these zero rates yielded surprisingly little improvement in progressivity. Far better to let the poor and the elderly pay the tax and provide them with a refundable tax credit roughly equal to what they paid. Not only would this be quite complicated, it would increase fraud and IRS enforcement actions to stem fraud.

  3. Tax reformers lambast the complexity of our income tax with good reason, but somehow assume that the same people who legislated that complexity will legislate a clean VAT. Again, the U.K. experience is very instructive. Their VAT is notoriously complicated, and so would be ours.

  4. I can't think of a faster way to kill Rust Belt jobs than to impose a VAT. That's because a VAT is a tax on wages plus old capital. Old capital would be doubly taxed because it was already taxed under the income tax and would be taxed again under the VAT. New capital would benefit under a VAT, but it would tend to create higher value added jobs that Rust Belt workers might not qualify for. Labor intensive industries would be particularly hard hit by a VAT.

  5. Housing would be hurt be a VAT even if it is zero rated. Studies have shown that approximately half of the economic gains from a VAT result from shifting capital from housing to business.

  6. Exporters would benefit from a VAT, but that benefit would be partially offset to the extend that the dollar appreciated against the currencies of our trading partners. Conversely, importers would be hurt with some relief from the dollar appreciation.

  7. State government sales tax revenues would be directly impacted by a federal VAT. That's why some have called for a portion of the federal VAT to be allocated back to the states. This would be an additional complication and would be subject to lots of political tinkering.
See this 1993 Congressional Budget Office study and my October 12, 2009 blog for more.

1) Shifting capital from

1) Shifting capital from housing to business is a really good idea.

2) I think you are mistaken about Rust Belt jobs. The key thing to remember is that the VAT doesn't just help exporters (which many Rust Belt businesses are) but also import-competing businesses (which a lot of other Rust Belt businesses are.) I haven't seen a study on this point, but I think this effect would dominate the tax on capital, especially considering the amount of ongoing investment done by these businesses.


Shifting Capital From

 Good points.  

Since the end of World War II, housing has always been a politically sensitive  and heavily subsidized industry.  There's no question the overall economy would benefit if those subsidies were redirected to the benefit of all.

Import competing businesses would definitely benefit.  I haven't seen any studies either on whether that dominates the double tax on old capital, but it probably does.


Why would giving a VAT credit

Why would giving a VAT credit to low-income people be difficult and particularly be subject to fraud? If the VAT credit were tied to income, All low income people would need to do to determine the eligibility for a full or partial credit is to state their income, which they already do, if they file a tax return.

Where I live (in a part of the world other than the US) this is how it is done. And it works nearly perfectly, as far as I know.


VAT credit for low income people

That's the problem.  Many would only file returns for the credit.  Some may already file for our Earned Income Tax Credit, but it will be difficult to separate those who file fraudulently from those who qualify.  Our poor often work sporadically in jobs paid by cash without withholding.


VAT at the borders only

An easier VAT to implement would be to equalize & reverse the VAT already rebated/charged by US trading partners - imports would be charged VAT at the rate of the country of origin and exports would be rebated at the rate they charge. This would level the playing field and raise revenue, since the US is a deficit country.


Question re: 2) You state

Question re: 2)
You state that the VAT is regressive compared to income taxation. Is the VAT regressive overall? If 2 is true, what advantage aside from political viability does the VAT have when compared with increasing the progressiveness of the income tax structure?


VAT regressivity

 A VAT is a proportional tax except for the effects of zero rated consumption goods.  Our income tax is somewhat progressive.  Given the problems I see with the transition to a VAT, I would prefer to increase the progressivity of the income tax.  If we could get beyond the transition problems, I would go along with a VAT, but only if it was not filled with loopholes.  I don't see any reason why the Congress that filled the income tax with loopholes wouldn't do the same to the VAT.


And why do we want to protect

And why do we want to protect rust belt jobs again? My understanding is that they are basically a misallocation of resources.

Also, a la the fair tax, why don't they just write everyone a check for the tax paid on necessities? That would be easy to administer and much harder to game.

Nevertheless, I'd agree that it sounds like this is an administrative nightmare, and I don't really get why you would particularly want it as opposed to other forms of taxation. Can anyone explain (I haven't been reading this blog, maybe you've been talking about it) why this is more popular of an idea than, say, a national sales tax?


John: We might not "want to"

John: We might not "want to" protect them, but politically it ain't happening if we don't, is it?


There's no faster way to get

There's no faster way to get me to cut my spending as a consumer than to impose a VAT tax. Won't other people think the same, too? How will that be for the economy?

I strongly agree that the whole tax base has already shifted to be too regressive and a VAT would be worse.

Why is Congress so captive? Law makers entertain everything but restoring the progressive income tax, which is what needs to happen first and foremost. We also need to tax capital gains the same as earned income (it is welfare for the wealthy not to).


disagree with logic

I disagree with your logic Pete. The most valid way to study a potential action is to look for its value if done properly. Not to look how an organization, in this case the British government, who could arguably be described as highly incompetent government, implemented an action.

If you to to VAT on everything; each wage, each benefit, each intracompany interaction; which would include each financial transaction (each CDO purchase, each derivative purchase, each stock option given), thereby not allowing the hedge fund people to escape their fair share of taxes through the pretense their income is capital gains instead of income; and eliminate all other taxes, thereby requiring that all taxes see the light of day, which most do not now; you would have a far more equitable system then now present. And detecting fraud would be no more difficult than today.

Then you could give a tax credit on all people who genuinely couldn't afford to pay the tax they owe, because they are too poor.

And please, enough of this nonsense of progressive and regressive. There is not a smidgen of evidence anywhere in the world, nor a rational argument to support the concept that the more you make the higher percentage you ought to pay. Every one has the inalienable right of life, liberty and pursuing what make one happy. So all poor people could become middle class or rich if they so wanted. So no one owes anyone else anything. Just have every one pay their share, the same share for everyone. Incidentally, I am middle class myself, in terms of my income.


Question re: regressivity of VAT

I am not as sophisticated a reader as many of the others who have commented here, but I can't quite get my mind around point #2 above.

- Everywhere I've ever lived there are different rates of sales tax for grocery items vs. other goods; is this not the case throughout the country? If so, the mechanism for "zero-rating" some items has been in place for decades, so I don't see how this could be construed as terribly burdensome.

- I feel like I need more info on the following statement: "My work with the Treasury Tax Model showed these zero rates yielded surprisingly little improvement in progressivity." Isn't the goal of a progressive tax structure to shift taxes to people with greater disposable income? If a person is truly in a subsistence position and they aren't paying taxes on food, housing, or medical services, then what are they paying taxes on? My sense is that there's little "improvement" because these individuals were paying virtually no taxes to begin with.

- "Far better to let the poor and the elderly pay the tax and provide them with a refundable tax credit roughly equal to what they paid." What? This seems like the worst possible way to do this. Wouldn't it be infinitely easier to simply not charge the tax to begin with? Furthermore, especially in very low income brackets, there's a huge difference between paying up front and waiting for reimbursement vs. not paying to begin with. As someone who has had some shaky times financially, I am always amazed when people don't realize this.

Perhaps someone with more depth in these issues can correct any flaws in my thought process. Any ideas from the group?


refundable tax credit

Although the refundable tax credit is a better solution then zeroing out some goods, I get a little nervous about the concept of paying people these huge lump sums once a year and expecting them to dole it out to themselves over the course of the year to make up for the increased tax.

Would it be better to think of some way of doing this over the course of the year (quaterly for example).


I suspect that Mr Davis'

I suspect that Mr Davis' concern about the complexity of the VAT system is based on his relative unfamiliarity with it. The VAT is complicated to get your head around, but once you become accustomed to the basic rules, it isn't particularly difficult to understand or administer.

Second, Mr. Davis largely assumes that existing income tax and sales tax structures and rates would not be changed if a VAT is implemented. Different VAT rates on food and medicine generally apply in Europe and these differential rates are not difficult to administer. To the extent the VAT adds existing regressivity to the tax system, some of it can be reversed by lowering income tax rates at the lower end of the scale. And, if done properly, states would "piggy back" on the federal VAT and eliminate their sales taxes. This could be an opportunity for simplification--not additional complexity.

Finally, I am surprised none of our experts have mentioned the potentially positive effect a VAT would have on our trade position. VAT is refunded on exports and imposed upon imports. This system has been ruled "trade neutral" and therefore not to constitute an unfair trade subsidy. If a VAT allows a reduction of general income tax rates (or other strictly local taxes), a country with low income tax rates and VAT can compete on trade better than countries with high income tax rates and no VAT. This is because income tax (and real estate tax, etc) is largely territorial and therefore imposed generally on local producers. Europe has been enjoying this advantage over the U.S. for decades.




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